Here's Why Dongsung FineTec (KOSDAQ:033500) Can Manage Its Debt Responsibly

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Dongsung FineTec Co., Ltd. (KOSDAQ:033500) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Dongsung FineTec

How Much Debt Does Dongsung FineTec Carry?

The image below, which you can click on for greater detail, shows that Dongsung FineTec had debt of ₩89.1b at the end of September 2020, a reduction from ₩110.1b over a year. However, because it has a cash reserve of ₩23.2b, its net debt is less, at about ₩65.8b.

How Strong Is Dongsung FineTec's Balance Sheet?

The latest balance sheet data shows that Dongsung FineTec had liabilities of ₩119.5b due within a year, and liabilities of ₩51.4b falling due after that. On the other hand, it had cash of ₩23.2b and ₩46.2b worth of receivables due within a year. So its liabilities total ₩101.4b more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Dongsung FineTec is worth ₩313.1b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

With net debt sitting at just 1.4 times EBITDA, Dongsung FineTec is arguably pretty conservatively geared. And this view is supported by the solid interest coverage, with EBIT coming in at 7.6 times the interest expense over the last year. Even more impressive was the fact that Dongsung FineTec grew its EBIT by 171% over twelve months. That boost will make it even easier to pay down debt going forward. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Dongsung FineTec can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last two years, Dongsung FineTec produced sturdy free cash flow equating to 62% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Happily, Dongsung FineTec's impressive EBIT growth rate implies it has the upper hand on its debt. And its conversion of EBIT to free cash flow is good too. When we consider the range of factors above, it looks like Dongsung FineTec is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Take risks, for example - Dongsung FineTec has 2 warning signs we think you should be aware of.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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